How to Find the Best-Performing Exotic Investments

Investors in self-storage, private equity, classic cars and lean hogs were among the winners in Bloomberg Markets' second annual ranking of alternative investments. Illustration by: James Taylor/Bloomberg Markets

Aug. 5 (Bloomberg) -- “I am a musician, and the monkey is
a businessman. He doesn’t tell me what to play, and I don’t tell
him what to do with his money.”

David Bonderman, co-founder of private-equity firm TPG
Capital, is doing his best French accent for the Beverly Hills
crowd, parroting a blind organ grinder confronted by Peter
Sellers’s Inspector Clouseau character in the 1975 film “The
Return of the Pink Panther.” The audience, gathered in April
for the Milken Institute Global Conference, erupts in laughter.
So does Leon Black, founder of Apollo Global Management LLC, who
is seated next to Bonderman.

Bonderman’s message is clear, Bloomberg Markets magazine
will report in its September issue. Like the film’s monkey and
organ grinder, alternative-asset managers and their investors
depend on each other. Bonderman, 71, and Black, 63, pioneers in
unconventional investments, can do business only when they raise
money from clients, and the clients are increasingly relying on
the $5.7 trillion universe of alternatives to meet their goals.

TPG and Apollo are among the leaders in the two categories
-- private equity and real estate -- that top Bloomberg Markets’
second annual ranking of alternative investments.

Private-equity firms’ buying and selling of companies
produced average returns of 14.9 percent annually over the three
years ended on Dec. 31 and 20.6 percent for the year ended on
the same date, according to data compiled by Cambridge
Associates LLC. And many of the deals alternatives giant
Blackstone Group LP and big private-equity firms such as Apollo
and TPG have brought home involved real estate.

Property Titan

Blackstone’s property unit manages more than $80 billion in
assets, with properties as varied as industrial warehouses in
the U.S., office parks in India, retail locations in Turkey and
Hilton Worldwide Holdings Inc., which operates more than 4,100
hotels with 685,000 rooms. Among Hilton’s properties is the
fabled Waldorf Astoria hotel in New York, whose guests have
included Winston Churchill, U.S. presidents and a host of other
world leaders.

McLean, Virginia–based Hilton, the behemoth lodging company
started in 1925 by Conrad Hilton, is a symbol of the real estate
recovery. Soon after Blackstone took it private in 2007 for $26
billion, distress in credit markets deepened and international
travel shrank as the global recession took hold. With its
investment marked down 70 percent in 2009, Blackstone took
action, restructuring the company’s loans, buying back debt and
opening new hotels around the world.

$11.5 Billion Profit

As occupancy rates have rebounded and room pricing has
crept higher, the $6.5 billion in cash Blackstone and its
clients plowed into the transaction had grown to more than $18
billion as of mid-July, making it the most profitable private-equity real estate deal ever. Since its new public offering in
December, Hilton stock was up 21 percent, valuing the company at
$23.8 billion. Blackstone still owns 66 percent.

The best bets ranged from the porcine to the sublime: from
lean hogs to antique cars to paintings by French-American artist
Marcel Duchamp, which returned 93.8 percent annualized over
three years and 465 percent over one. Other winners were various
vintages of Chateau Pavie in Bordeaux and a 1954 Mercedes-Benz
race car.

Hedge Funds Falter

As a group, alternatives struggled to beat the Standard &
Poor’s 500 Index, which returned 14.6 percent annualized over
the three years ended on March 31 and 21.7 percent for the year
ended on that date. Among the worst-performing alternatives were
global commodities, which declined 3.4 percent over the three
years, and hedge funds, which gained 1.9 percent on average,
according to data compiled by Bloomberg. Funds of hedge funds
lost 1.9 percent. A $2.8 trillion industry, hedge funds have now
underperformed the S&P 500 for more than five years.

“Returns have been anemic, and I think that’s going to be
more of an issue for the hedge-fund space,” says Jim Dondero,
president of Highland Capital Management LP in Dallas. “Hedge-fund returns have been less than mutual fund returns for almost
a decade.”

$1 Trillion in REITs

REITs are agglomerations of property sold like stocks. They
own more than $1 trillion of property in the U.S. and raised a
record $77 billion last year, up from $73 billion in 2012,
according to the National Association of Real Estate Investment
Trusts, or NAREIT. One category of REIT that soared was
operators of self-storage units, with Salt Lake City–based Extra
Space Storage Inc. the top performer, returning 36.7 percent
over three years.

Despite average or lackluster returns, investors are still
pouring money into alternatives, led by rich individuals,
pension funds, endowments, family offices and sovereign wealth
funds. It took more than 20 years for the world’s largest
alternatives managers to build their assets to a collective $420
billion, which happened in 2009, according to Goldman Sachs
Group Inc. It took just four years to double that figure to $835
billion. Chris Geczy, a finance professor at the University of
Pennsylvania’s Wharton School, says institutions should continue
to allocate a portion of their money to alternatives.

Diversification

“I would argue that the percentage for almost everyone
should be larger than 10 percent,” he says. “Making these
sorts of moves could have a benefit in terms of enhanced
diversification.”

Investors are particularly drawn to real estate. In a May
survey by researcher Preqin Ltd., 82 percent of asset managers
said client appetite for real estate investments grew in the
prior year. Two-thirds said they planned to plow more capital
into property in the 12 months after May than they did in the
previous 12 months. Real estate investments were dragged down by
the subprime mortgage meltdown that set off the financial
crisis, with housing prices in the U.S. plummeting 35 percent
from their 2006 peak to the 2012 trough, according to an
S&P/Case-Shiller index that covers 20 cities. With increased
demand and a lack of new supply, the index has since gained 26
percent as of mid-July.

‘Quick and Easy’

“We’ve had a lot of quick and easy gains, given the fact
that values fell so dramatically,” says Michael Hudgins, a real
estate strategist at JPMorgan Chase & Co. in New York.

For U.S. investors, the biggest attraction of REITs is
their dividends. REITs, in exchange for paying little to no
corporate income tax, are required by the Internal Revenue
Service to pay out at least 90 percent of their taxable earnings
to shareholders.

“You get a pretty attractive dividend yield, and, on top
of that, in an economic expansion you’re going to get growth in
that dividend stream,” says David Wharmby, a managing director
at Hartford, Connecticut–based Cornerstone Real Estate Advisers
LLC.

The dividend yield of the FTSE NAREIT All Equity REITs
Index was 4.43 percent at the end of 2013.

What worries some analysts is that REITs are returning to
their pre-2008 habit of funding purchases with debt. Taking
advantage of Federal Reserve benchmark interest rates near zero,
REITs borrowed 40 percent of their investment funds in 2013,
according to NAREIT. Issuance of commercial mortgage-backed
securities doubled to $80 billion in that year.

From 2009 through 2011, it was commodities -- metals in
particular -- that helped make the alternative markets sing, as
China filled its warehouses with copper, zinc, aluminum and
steel to support its building boom. With China’s growth slowing,
demand for metals has waned and so have returns to investors. At
the same time, steady global growth has eroded gold’s allure as
a haven and suppressed its once highflying price, with returns
from gold investments down 3.6 percent for the three years ended
on March 31 and 19.5 percent for one year.

“There is not much interest in gold as U.S. economic
conditions improve,” says George Gero, precious-metals
strategist at RBC Capital Markets LLC in New York.

Commodities Fall

Globally, commodities investors on average lost money
during the three years ended on March 31 and eked out a 1.1
percent gain in the one-year period, according to the S&P GSCI
Total Return Index. The outlook isn’t improving: Commodities are
poised to fall 5.5 percent in the year ending in June 2015,
Jeffrey Currie, head of commodities research at New York–based
Goldman Sachs, wrote in a June 23 report.

“We see significant downside for agriculture and precious
metals,” he wrote. Notwithstanding the turmoil in Iraq, one of
the world’s largest oil producers, Currie doesn’t predict a
sharp rise in petroleum prices either.

Investors in some agricultural commodities have done well
in the past three years -- and none better than those who put
their money into pigs. Contracts to buy and sell lean hogs, the
source of the majority of pork in the U.S., delivered a 56.3
percent return in the year ended on March 31, with gains driven
by a drop in supply as a diarrhea-causing virus killed pigs in
at least 27 states. Over the three-year period, lean hogs
produced an annualized return of 11.5 percent.

Antique Cars

Wealthy investors who missed the spike in pig prices could
have profited from investing in classic cars. The Historic
Automobile Group International TOP index ended 2013 at an all-time high, with 21 percent gains for one year and 40.7 percent
over the three years ended on March 31. Big sales in the past
year included a record-setting $29.5 million for a 1954
Mercedes-Benz W196 Grand Prix race car and $10 million–plus
price tags for a slew of Ferraris from the 1950s and 1960s.
Bonhams, the British auction house where the hammer fell to
conclude bidding on the Mercedes, says it went to an
unidentified private buyer bidding by telephone. The silver
racer was driven by Formula One legend Juan Manuel Fangio, who
died in 1995.

“If he were here today, Fangio would shake his head and
smile his slow smile” at the car’s price, says Doug Nye, a
racing historian in England. “He was a humble man.”

Wine Loses Value

Among other exotic alternatives, rare coins rolled out
gains of 13.2 percent over three years. One 1583 British gold
piece appreciated 22.9 percent. Stamps produced single-digit
percentage gains, and collectible wine on average lost value,
including a 9.6 percent decline in the three years ended on
March 31.

Investors fortunate enough to hold on to bottles of wine
from Chateau Pavie in the Bordeaux region of France, however,
saw gains as high as 24.1 percent in the three years. During a
June auction in The Bowery Hotel in New York, the 1982 vintage
of Chateau Mouton Rothschild, from Bordeaux, sold for more than
$1,000 a bottle. A single bottle of Henri Jayer Echezeaux, from
Burgundy, sold for $4,014.

On a larger scale, no alternative investment category is
more vigorous than private equity. Wealthy families and
institutions poured $454 billion into private-equity funds in
2013, and public pension funds are still well below their 7.8
percent average target asset allocation to the industry,
according to data provider Preqin.

Rush Into PE

“I’ve never seen so many investors enter the private-equity space,” says Antoine Drean, chairman of Triago SA, a
Paris-based group that helps private-equity firms raise money.
“We are seeing a lot of appetite.”

Much of that investment is cash recycled after payouts.
Distributions to limited partners in buyout funds totaled more
than $1 trillion from 2011 to 2013, according to Preqin, as
firms took advantage of rising stock markets to sell their
companies, a process known as exiting. For publicly traded
private-equity firms, money earned from exits has flowed through
to stockholders as dividends, fueling a surge in share prices.

Blackstone shares more than doubled from 2011 to 2013, and
in December 2013 surpassed the $31-per-share IPO price for the
first time since 2007, when the firm went public. Black’s
Apollo, which went public in 2011 at $19, closed out 2013 above
$31.

Dry Powder

The same forces propelling markets are also raising prices
for companies private-equity firms want to buy. Dry powder --
buyout money that has yet to be deployed -- stood at a record
$1.16 trillion as of June 30, according to Preqin.

“Prices are very high,” Black said at the Milken
Conference. “It’s still not a robust environment for private
equity. We are continuing to sell more than we are buying.”

The combination of too much dry powder and a great deal of
demand has created a dilemma for executives such as Blackstone
President Tony James, whose firm manages a total of $279 billion
in alternative investments. He says Blackstone has been turning
away money because the New York-based firm can’t find prudent
ways to spend it.

“It tears us up to see all that unsatisfied demand go to
our competitors,” James said on a July conference call with
media and investors.

It’s a conundrum that few observers would have predicted
when the engine of finance was flying apart five years ago.